Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 43

What do fund managers mean by Quality Investing?

Since 2010 global markets have witnessed a flight to yield and quality. In Australia this has been more a flight from resources, but the result is the strong performance of financials, utilities and staples. Investors are looking to invest in companies that are of high quality, are stable, and have steady cash flows. They are looking for stocks that pay regular dividends, and particularly in low interest rate environments, even begin to look like bonds. But successful quality investing means looking at many different factors, and quality investing is definitely not new.

Value investing, on the other hand, is about buying stocks cheaply. An investor may select a group of stocks based on valuation metrics such as high dividend yield or low price-earnings ratio. These metrics will tell you if a stock is cheap but tell you nothing about how healthy the company is. For example, a stock that is in financial difficulty is cheap for a very good reason. This is when quality measures are useful. Quality looks at the health of a firm based on information in the financial statements thus allowing an investor to avoid poor quality firms that are cheap, also known as ‘value traps’.

How is quality measured?

Quality investing extends back to the work of Benjamin Graham in his 1949 book The Intelligent Investor. Whilst Graham is considered the father of value investing the book also indicates he is also the founder of quality investing with the important claim that the greatest losses in share prices come not from buying quality at an excessively high price but, rather, from buying low quality at a price that seems like good value.

Quality measures gained popularity after the burst of the dot com bubble and the spectacular failures of companies such as Enron and WorldCom. More recently the global financial crisis and subsequent sovereign credit crisis has resulted in a resurgent interest in quality measures.

But how do we measure quality? There is no one specific measure, but most of these methods look to identify companies that have high predictability of earnings and if possible earnings growth. Some investors start with companies with strong branding, good governance, and well-defined customer base. Others look for staple products, large distribution, and input costs that are easily controlled and modelled.

One of the most popular measures is Piotroski’s F-score developed by Joseph Piotroski and published in his 2000 paper, “The use of financial statement information to separate winners from losers”. Starting with a portfolio of value stocks, Piotroski looked at whether it was possible to improve performance by eliminating those of the lowest quality. He did this by scoring a stock on nine metrics. For each metric that is met a stock is scored one point as a sign of strength, but if it is not met then zero is assigned as a sign of weakness. The scores are then aggregated to a score out of nine for each stock. The higher the score, the better quality the company.

The nine individual measures of the Piotroski F-score are:

1. Positive return on assets (ROA) in the current year

2. Positive operating cash flow (OCF) in the current year

3. Higher return on assets in the current year than the return on assets in the previous year (ROAX)

4. Cash flow from operations greater than net income (ACCRUAL)

5. Lower ratio of long term debt to assets in the current year compared to the previous year (LEVERAGE)

6. Higher current ratio this year compared to the previous year (LIQUIDITY)

7. No new shares were issued in the last year (EQUITY)

8. A higher gross margin compared to the previous year (MARGIN)

9. A higher asset turnover ratio compared to the previous year (TURNOVER)

Each of these measures captures different aspects of a firm’s health.

The first three measures capture profitability or whether the firm can generate funds through operating activities.

The accrual measure is an earnings manipulation factor and is widely known in earnings quality research. Accruals are measured as the difference between profits and cash flow from operations. If a company is reporting positive accruals, its management could be manipulating earnings by ‘borrowing’ earnings from future cash flow.

Three of the signals measure changes in capital structure. Leverage looks at the firms long-term debt levels. A company that increases its long term debt perhaps cannot generate sufficient internal funds from its business. Similarly companies that raise external capital by issuing new shares could be signalling their inability to generate sufficient internal funds. Change in current assets to current liabilities is known as liquidity. A company which has improving liquidity is a good indicator about its ability to pay its debt obligations.

The remaining two signals are designed to measure changes in the efficiency of the firms operations. An improvement in margins could mean an improvement in managing costs and/or a rise in the price of the firm’s product. An improvement in asset turnover signifies greater productivity from the assets. This can come either from more efficient operations or an increase in sales.

Strengths and weaknesses of the measures

Individually, the nine measures have at times been labelled as weak and having limitations. But together they are a broad brush that can be applied to an index or a large portfolio, and successfully identify companies that are having financial difficulty. Most companies will score in the range five to seven, and they are likely to be safe. But a company that is only scoring one or two out of a possible nine really needs to be looked at very closely.

In the Australian market stocks with low f-scores (scores three or less) tend to demonstrate falling earnings, a reduction in dividends, lower share price performance and increased share price volatility. Companies scoring eight or nine tend to have the opposite characteristics, and portfolios made from high quality value stocks have outperformed over the long term.

Quality measures work best in down markets when investors are looking for certainty. It performs best during a recession (e.g. the tech wreck in the early 2000’s and the GFC). It tends to only perform poorly during speculative periods of ‘irrational exuberance’ such as the dotcom bubble (late 1990’s-2000) and the resources boom of 2004 to 2007. During these environments risk appetite increases and investors are willing to speculate on low quality companies. In the sideways market of 2010-2012, following the strong rebound in 2009, market and thematic certainty disappeared and investors moved towards stock level earnings certainty.

In conclusion whilst there is no single measure to define what a quality company is, there are a number of combined metrics which can indicate the overall financial health of a company and provide indications of quality. These measures can certainly help to provide some downside protection especially in more benign or tough market conditions.

Raelene De Souza is a Portfolio Manager at Realindex Investments.


Leave a Comment:



The Harry Markowitz Interview, Part 1: Portfolio Selection

This is mean (-reverting that is)

Know who’s managing your business


Most viewed in recent weeks

10 little-known pension traps prove the value of advice

Most people entering retirement do not see a financial adviser, mainly due to cost. It's a major problem because there are small mistakes a retiree can make which are expensive and avoidable if a few tips were known.

Check eligibility for the Commonwealth Seniors Health Card

Eligibility for the Commonwealth Seniors Health Card has no asset test and a relatively high income test. It's worth checking eligibility and the benefits of qualifying to save on the cost of medications.

Hamish Douglass on why the movie hasn’t ended yet

The focus is on Magellan for its investment performance and departure of the CEO, but Douglass says the pandemic, inflation, rising rates and Middle East tensions have not played out. Vindication is always long term.

Start the year right with the 2022 Retiree Checklist

This is our annual checklist of what retirees need to be aware of in 2022. It is a long list of 25 items and not everything will apply to your situation. Run your eye over the benefits and entitlements.

At 98-years-old, Charlie Munger still delivers the one-liners

The Warren Buffett/Charlie Munger partnership is the stuff of legends, but even Charlie admits it is coming to an end ("I'm nearly dead"). He is one of the few people in investing prepared to say what he thinks.

Should I pay off the mortgage or top up my superannuation?

Depending on personal circumstances, it may be time to rethink the bias to paying down housing debt over wealth accumulation in super. Do the sums and ask these four questions to plan for your future.

Latest Updates

Investment strategies

Three ways index investing masks extra risk

There are thousands of different indexes, and they are not all diversified and broadly-based. Watch for concentration risk in sectors and companies, and know the underlying assets in case liquidity is needed.

Investment strategies

Will 2022 be the year for quality companies?

It is easy to feel like an investing genius over the last 10 years, with most asset classes making wonderful gains. But if there's a setback, companies like Reece, ARB, Cochlear, REA Group and CSL will recover best.


2022 outlook: buy a raincoat but don't put it on yet

In the 11th year of a bull market, near the end of the cycle, some type of correction is likely. Underneath is solid, healthy and underpinned by strong earnings growth, but there's less room for mistakes.


Time to give up on gold?

In 2021, the gold price failed to sustain its strong rise since 2018, although it recovered after early losses. But where does gold sit in a world of inflation, rising rates and a competitor like Bitcoin?

Investment strategies

Global leaders reveal surprises of 2021, challenges for 2022

In a sentence or two, global experts across many fields are asked to summarise the biggest surprise of 2021, and enduring challenges into 2022. It's a short and sweet view of the changes we are all facing.


What were the big stockmarket listings in record 2021?

In 2021, sharemarket gains supported record levels of capital raisings and IPOs in Australia. The range of deals listed here shows the maturity of the local market in providing equity capital.


Let 'er rip: how high can debt-to-GDP ratios soar?

Governments and investors have been complacent about the build up of debt, but at some level, a ceiling exists. Are we near yet? Trouble is brewing, especially in the eurozone and emerging countries.



© 2022 Morningstar, Inc. All rights reserved.

The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.